Crisis Is Over, but Where’s the Fix?

When the financial system began to crumble more than three years ago, the world rushed to rescue it. Country after country went deeply into debt to keep banks afloat and prevent a deep recession from turning into something worse.

It worked. This week was the second anniversary of the nadir of the crisis. Most stock markets around the world are at least 75 percent higher than they were then. Financial stocks, which led the markets down, have also led them up.

At the time, rescuing seemed more important than reforming. The world economy was breaking down because of a lack of financing. Trade flows collapsed, and companies and individuals stopped spending. It seemed clear that halting the slide was critical.

But the world has changed since then. The economic recovery in most developed countries is stuttering at best, and governments are struggling with their own finances. It is time for remorse and second-guessing.

The researchers, Stijn Claessens and Ceyla Pazarbasioglu, warned that “a rare opportunity is being thrown away to tackle the underlying causes. Without restructuring financial institutions’ balance sheets and their operations, as well as their assets — loans to over-indebted households and enterprises — the economic recovery will suffer, and the seeds will be sown for the next crisis.”

There have been reforms, of course. The Dodd-Frank law in the United States is now being put into effect, albeit by regulators that the new Republican majority in the House of Representatives seems determined to starve of resources to do the job. Banking regulators around the globe have agreed that much more capital is needed by banks, but stricter requirements are coming very slowly out of fear that abrupt changes will reduce bank lending when it is needed the most.

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Adair Turner, a British regulator, said it was “quite difficult to work out the social benefit” of predatory trading practices.Credit
Chris Ratcliffe/Bloomberg

More capital is clearly needed, but it may not be nearly enough. “If we ask them for more capital, and they are too big to fail, they can take even more risk” after they raise additional capital, Y. Venugopal Reddy, a former governor of India’s central bank, argued at an economic conference sponsored by the I.M.F. this week. He added that he was worried about institutions that were “too powerful to regulate.”

One of the questions economists were asked to address at the conference was, Does the financial system have social value?

A few years ago, that question would not have been asked at the International Monetary Fund. If it had been, the responses would have been as unanimous as might be expected if a gathering at the Vatican were to consider whether religion was a good thing.

Now, there is no such unanimity. It is clear that there are functions of the financial system that must be performed, among them the allocation of capital and the setting of prices. But there is at least a suspicion that a significant part of modern finance has no real value for anyone except the participants.

Adair Turner, the chairman of Britain’s Financial Services Authority, spoke with wonderment of the huge volume of stock trades now made by computers using algorithms to rapidly trade in and out. Some traders, he said, were using what they called “predatory algorithms,” whose sole purpose is to exploit a weakness in some other trader’s algorithm and get it to make an unprofitable trade.

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“It is quite difficult to work out the social benefit of that,” he said.

And of course, there is also the fact that the financial system did not accomplish what it was supposed to do. “At the core of these functions is the ability to find and set the right price, including the extent to which it reflects risk,” Antonio Borges, an I.M.F. official and former vice chairman of Goldman Sachs International, told the conference. “This is not really a question of financial sophistication, of complex products or greedy bankers. It is a question of getting the prices wrong.”

There is general agreement that many of the assumptions economists and others made before the crisis — about the rationality of markets, about their ability to measure risks and about the proper role of monetary policy — were largely wrong, or at best oversimplified. But there is far less unanimity about what to do about it. International cooperation was impressive in dealing with the immediate crisis. Now it is splintering, and banks are threatening to move operations to areas they deem friendlier to them.

In retrospect, it is clear that the bailouts came with too little pain for those responsible. Bondholders who financed banks that failed largely escaped pain. That was true even in Ireland, where the bailout would have led to a default of government debt had Europe not stepped in. It is still not clear how Ireland will pay its national debt, but the bank bondholders did fine.

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At the time, of course, there were fears that forcing bondholders to suffer would lead to the collapse of banks that could have survived. Those fears seemed reasonable to me then, and still do. But little progress has been made in setting up mechanisms to assure that any future crisis can be dealt with in a different way. There is talk of restructuring bank balance sheets to assure that debt is automatically converted to equity just when equity seems to be worth little, but that is unlikely to happen unless regulators force it, and it is far from clear what price investors would demand.

Moreover, as Mr. Turner noted, it is important to somehow assure that those who would suffer from such a conversion are not themselves so leveraged that a crisis would be intensified. Something like that seems to have played a role in Europe’s decision to avert a Greek national default. Most of the Greek debt was owned by European banks, and it was doubtful that they could afford to take the losses.

Perhaps the most important error made early in the crisis was a decision by Henry Paulson, then the United States Treasury secretary, to put pressure on big banks to accept bailouts whether they needed them or not. The idea was to avoid making acceptance of such money a scarlet letter that would in itself alarm depositors and investors. It seemed to make sense.

But it also meant that it was not clear which managers had led their banks over — or at least close to — a cliff. There was an unmet need to establish the principle that, in Mr. Reddy’s words, “When the profits are good, you take your bonus. When something goes wrong, you go out and somebody else comes in.”

The principle is particularly important because regulatory failures may be inevitable. If multimillion-dollar bank bosses do not see a crisis looming before it is too late, can we be sure regulators who work for far less will be more prescient? Markets clearly did a horrid job of allocating capital, but there is no particular reason to think governments would do better.

Even if regulators somehow did design a perfect regulatory system, it would not last, simply because clever bankers would eventually find ways around it, just as people find ways to evade taxes, forcing tax law writers to constantly make changes.

“Every decade or so,” said Paul Romer, a senior fellow at the Institute for Economic Policy Research at Stanford and now a visiting professor at New York University, “any finite system of financial regulation will lead to systemic financial crisis.”

If he is right, it is all the more important that ways be found to assure that the costs of the next financial crisis — in failed institutions and lost economic growth, not to mention government borrowing — will be far lower. It is hard to conclude much progress has been made in accomplishing that goal.

A version of this article appears in print on March 11, 2011, on Page B1 of the New York edition with the headline: Crisis Is Over, But Where’s The Fix?. Order Reprints|Today's Paper|Subscribe